Room to let

Another sector of the new economy looks set for a shake-up. Richard Fletcher investigates the prospects of internet hotels

THE future of the latest hi-tech service industry hangs in the balance after dismal results from one of the sector's leading operators raised fears that margins will come under pressure as competition intensifies.

Internet hotels - where firms can rent customised space for their servers and telecommunications equipment - may not sound very hi-tech but they have become the latest craze as investors rush to invest in internet infrastructure

The sales pitch is simple: as internet usage grows, companies will increasingly check their web site, intranet and data storage into the secure, temperature controlled environment of an internet hotel where it will all work faster and more efficiently. Rather than room service, the guests in internet hotels are offered instant access to huge bandwidth, an uninterruptable clean power supply and on-site technical expertise.

Over the last year nearly a dozen companies have unveiled ambitious plans to open internet hotels across Europe, including: MWBKonnect, a joint venture between property company Marylebone Warwick Balfour and internet incubator Antfactory; Redbus Interhouse, which reversed into listed Horace Small earlier this year; Global Switch, a company backed by Chelsfield, the property company run by Elliott Bernerd, and Toronto-based real estate group TrizecHahn; and IX Europe, which plans to float next month.

But last week one of the leading developers of internet hotels, Telecity - which floated in June after abandoning a float in May because of adverse market conditions - shocked the City with disappointing third quarter revenues. City traders wiped £300m off the value off the company as analysts slashed full year sales forecasts by 25 per cent.

The results sparked warnings that internet hotels, also described as co-location centres, faced a bleak future.

Milan Radia, an internet infrastructure analyst at UBS Warburg, warns that prices and margins will fall before the end of next year. "Without a doubt there will be a glut of internet hotels. The same cities come up again and again in company announcements. The market for co-location services is going to be increasingly difficult into the next year, that is clear.

"By the end of next year there will be a huge amount of capacity added to the European stock of internet hotels. That will drive down prices and margins," he added. Ramina draws comparisons with the market for fibre optic capacity. Over the last few years a huge amount of cable has been laid, with supply in many cities vastly exceeding the demand.

The glut has led to dramatic fall in the cost of leasing cable. For example, a 15-year lease on a transatlantic circuit, which would have cost $16m in 1997, now costs about $850,000. Gareth Evans, an analyst at ABN Amro, agrees that competition is set to intensify. "In the very short term there are significant returns to be be made, but there is only a limited demand," he argues.

Evans warns that internet hotels will face stiff competition from a number of well-funded US companies which have significant European expansion plans and telecommunication companies, and which are desperate to fill their bandwidth capacity. "The telcos will cross-subsidise and I doubt that the competition authorities will step in," he says.

Mike Kelly, chief executive of Global Switch, claims that the City has overreacted. "We are seeing strong demand and a fantastic market," he insists. Quizzed on increased competition, he says: "I don't think running a co-location centre is actually as easy as people think."

Richard Balfour-Lynn, chief executive of Marylebone Warwick Balfour, says he has no doubts about the strength of the demand. He compares the roll-out of internet hotels to the construction of telephone exchanges 70 years ago. "There is not just a fashion," he says, insisting that the huge shortage of supply is not just a short-term trend.

Nigel Downton, director of sales at Global Switch, argues that even if competition does intensify operators will be able to maintain margins by offering added-value services. "What we provide is a layer of services on a contract or pick and pay basis," he says.

But Ramina is not convinced. He says: "We are seeing signs of reluctance among application service providers - an important market for co-location centres - to hand over some of value-added services to the operators."

And John Porter, chairman of Redbus Interhouse, is sceptical about the ability of many of his competitors to offer added-value services. "If you start on the property side and you offer value-added services the chances are you are going to come a cropper," he says.

Porter - who was warning that the sector could catch a bit of a cold even before Telecity shocked the City - believes that demand for the "right type of space" will hold up. But many observers believe that the ambitions of many of the operators will be constrained by other factors.

Tony Edgley, a director at property consultants Jones Lang LaSalle, says: "The limitations on the availability of suitable buildings and more importantly a shortage of the huge amounts of electricity needed to power internet hotels is likely to stall the roll-out program of many of the companies looking to enter the market."

Following the collapse in Telecity's share price operators may also find the availability of capital is somewhat constrained. The City is certainly questioning the valuations being placed on many of the operators.

One investment banker says: "I see no reason why these companies should not be valued on net asset value - like any other property-based company."